Using Return on Capital Employed (ROCE)

Return on capital employed is a type of valuation multiple that is commonly used by investors in order to value companies. This ratio gives a more accurate indication of the profitability of a company than some of the other ratios that are commonly used for this reason. Here are the basics of return on capital employed. 

Return on Capital Employed

The return on capital employed is a measure of how much money the company brings in, in relation to the amount of capital that it has employed. In order to calculate the return on capital employed, you would take the net income of the company and divide it by the capital employed. In order to calculate the capital employed, you can add average debt liabilities and the average shareholders equity. Instead of net income, some people also like to use the operating income of a company as the numerator of this equation. 

What it Tells You

This ratio can provide you with a good idea of how efficient a company is with the capital that they have used. Other ratios might look at similar factors, but this ratio take into consideration debt and equity. This gives you a more realistic look at how the company is doing because you are taking all of the important factors into consideration.

Using the Ratio

If you perform this calculation and you come up with a number, this number does not necessarily tell you everything that you need to know. In order to use this ratio, you need to be able to compare it to something. When you are using this number, you need to compare it to other companies that are in the same industry as the company you are looking at. By comparing this ratio against other companies, you will be able to see how they are doing compared to other companies that have similar situations. If you compare it to other companies that are not in the same industry, you will not get as good of an idea as to how the company is doing. Some industries are more capital intensive than others which can skew the comparison.

Potential Drawbacks

Even though this is a useful ratio to use when looking at a company, it is not perfect by any means. There are some potential drawbacks that you should be aware of when using this tool. For example, some critics have pointed out that this ratio favors older companies that have been around for a number of years over new companies even if the new companies could be better off. This is because older companies have been able to depreciate their assets for a longer amount of time and this will affect the ratio in their favor. 

Inflation can also have an impact on return on capital employed. Inflation could potentially increase the amount of net income but it will not necessarily affect the book value of the assets of the company. 

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